Downside of tax cuts: Less profitable muni loans

Most bankers grin at the mention of corporate tax reform because of the many ways it could boost profits, but little discussed has been the toll it could take on one of banking’s most popular niches — lending to municipalities and other government entities.

Commercial banks' loans and leases to states and other political jurisdictions rose 131% to $152 billion at June 30, 2015, compared with the same period five years earlier, according to the latest data from the Federal Deposit Insurance Corp. That growth outpaced the rate of all loans and leases, which rose 26% in the same period.

Banks are not required to pay taxes on the interest income they receive from loans to cities, counties, school boards, highway commissions and other governmental entities; that tax savings widens their profit margins and offers more flexibility in pricing loans compared with rates for standard commercial loans.

Because the savings would be smaller at, say, a 25% tax rate than a 35% tax rate, banks would have to decide whether they want to charge higher rates — and risk losing customers — or gamble that they could make up the lost earning potential through increased volume. After all, President Trump has proposed spending $1 trillion to upgrade the nation’s infrastructure, and commercial banks would be involved in financing at least some of those projects.

“In the long run, lower tax rates are a good thing for banks,” said David Wood, an accountant at Porter Keadle Moore in Atlanta who advises banks on tax strategies. “But lower taxes would mean a smaller benefit on municipal loans.”

President Trump has said that he wants to lower the corporate tax rate from 35% to 15%. Details of Trump’s proposal have not yet been released, although many observers think a more realistic target would be a reduction to 20% or 25%.

In effect, banks would need to charge municipal borrowers a higher interest rate to earn the same profit, said Dennis Zember, chief financial officer at the $7 billion-asset Ameris Bancorp in Moultrie, Ga. Some banks may decide to underprice the market to win new business, he said. Other banks may decide they don’t want to raise rates on longtime municipal customers.

The same principle applies to banks’ holdings of municipal bonds in their securities portfolios. Banks would receive a smaller tax benefit from muni bonds if their corporate tax rate is lowered. That may cause some banks to sell muni bonds in exchange for other securities, or reduce future demand for buying muni bonds, said Lisa Washburn, managing director at Municipal Market Analytics, a research firm in Concord, Mass.

Bank lending to cities, counties, hospital authorities, school boards and other types of government entities started to boom in 2009, Washburn said. Municipalities and other government borrowers shifted to bank loans because they are cheaper than issuing bonds since they do not require ratings and their disclosure costs are smaller.

Banks like the lending segment because municipal defaults are extremely rare, and it generates tax-free net interest income. Municipalities take out loans for everything from covering interest payments on bonds to building new roads. In one recent large transaction, Wells Fargo purchased a total of $147 million of bonds issued by the Kansas Department of Transportation and converted them into a single loan.

Even with a lower tax rate that could diminish the attractiveness of municipal lending, banks continue to jump into the sector. The $1.1 billion-asset Evans Bank in Buffalo, N.Y., last month hired Marc O’Hearn to lead its newly created government-lending business. O’Hearn had recently left First Niagara Bank after its acquisition by KeyCorp.

Other banks that have publicly stated that they’re expanding municipal lending include the $39 billion-asset Signature Bank in New York and the $9 billion-asset Glacier Bancorp in Kalispell, Mont.

As the space has become more competitive, and as tax reform may reduce its benefit, some banks may decide to get out of business of municipal lending. Zember said he does not think that will happen at Ameris. In fact, municipal lending has been such a good business for Ameris that it plans to keep its business under wraps.

“It’s been so profitable, we haven’t wanted anyone else to know about it,” Zember said.

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